Know about Stock market and mutual fund basics

 How is the stock market today? The answer to this common question is in the form of a number, which is an index, such as the BSE Sensex or NSE Nifty. Imagine there is no index. How would we gauge the performance of the stock market?

How would we know whether the stock market has gone up or down? In fact, till 1986, there was no index in India. In 1986, the Bombay Stock Exchange compiled the Sensex. The base year for calculation was taken as 1978-79 and base value was 100. So, we can say that the stock market, which today is at around 10000 level, was at 100 in 1978-79.

An index is a representative number which indicates the current position and helps to compare the movement of the stock market. For example, when we say the temperature at noon in Mumbai has risen to 38 degrees celsius from yesterday’s temperature of 36 degrees, it is a movement of a representative number.

There could be some places like open grounds where the temperature could be more than 38 degrees today and could have been 35.5 degrees yesterday. Similarly, if we stand on the ocean front below a tree, the temperature could be 37.5 degrees today and could have been 36 degrees yesterday. However, as long as the majority of the region has a temperature of around 38 degrees today and had 36 degrees yesterday, it is a well-represented number.

Similarly, if the Sensex was at 10000 yesterday and is at 10250 today, it is an upward movement of 2.5%. This logically indicates that the majority of shares have moved up by 2.5%. Obviously, some stocks would have fallen, and similarly, there could be some stocks which have risen more than or less than 2.5%.

However, as long as the average has moved around 2.5%, the index is said to be well-represented and serves its purpose (the actual movement of the Sensex depends on the market capitalisation and weighted averages.)

The Sensex or Nifty are representatives of the stock market. If we were able to invest in these indices, we would get (stock) market returns. In 1992 — during Harshad Mehta’s time — there used to be a joke. A man who had come from a village wanted to invest in the stock market.

Not knowing which scrip to buy; he said he wanted to invest in the Sensex, as it kept going up routinely. That joke is a reality today. There are mutual fund (MF) schemes which are called index funds. An investor can invest in MF schemes which replicate index stocks in its portfolio.  For example, the Sensex Index Fund will only invest in those 30 companies which are constituents of the Sensex. By investing in a Sensex Index Fund, the investor is indirectly buying the Sensex.

Index funds for the common investor were first introduced in the US in 1976 by Vanguard Group. The founder of the Vanguard Group, John Bogle, as part of his senior thesis in Princeton University, had studied the MF industry and its practices in detail.

He made several important observations: 1. The order of top-performing funds is continuously changing. This means there isn’t any MF which consistently remains the top-performing category year-on-year.

Also, it is only in hindsight that one will know which funds were top performers in the previous year. 2. Sales, marketing and other administration expenses are eating away returns generated by fund managers. 3. All fund managers are not consistently able to beat market returns (read indices returns).

Index funds are passive form of investing. This means the fund manager does not use any of his/her skills in stock-picking. There is absolutely no research needed. A fund manager simply invests money in all those companies which are constituents of the index.

This will save MFs huge costs. Funds where a fund manager uses his/her skills in stock-picking are called active funds. In India, active funds usually charge annual expenses in the range of 2-2.5%.

Compared to this, passive funds (index funds) charge around 1.1-1.4%, which results in a saving of about 1% every year. It is important to note that in mature markets, the difference in cost between active and passive funds is higher.

While it is true that active funds are usually top performers, it is also true that the same funds rarely retain their top slots continuously. The caveat that past performance may not be repeated is true. On the other hand, though index funds are not the best performers, they are consistently above-average performers.

In India, private sector MFs began their journey in 1993. The erstwhile Kothari Pioneer Mutual Fund Company — now Franklin Templeton Mutual Fund Company — was the first to launch diversified (active) equity funds. The past 13 years’ record suggests that fund managers are able to beat the index returns consistently; but as the market matures further, efficiencies increase and this becomes more and more difficult.

An efficient market is one where all the news and information about a company is disseminated to all current and potential investors equally and simultaneously. Therefore, all investors — big and small — take informed decisions. In developing markets, larger investors have better access to news and information and hence, they are able take more prompt action on the investments, thereby beating the market returns.

Over a period of time, as our market matures and becomes more efficient, fund managers will struggle to beat market returns (read indices). Under such circumstances, expenses will play a major role. Funds with lower expenses like index funds will turn out to be winners. Therefore, one must keep track of index funds too.

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